A simple guide to pensions changes
Last week saw the most radical changes to pensions announced in decades! But are you struggling to filter through the jargon? Don't know what the best option for you will be? Well fear not as Martin Lewis is here with everything you need to know about pensions!
1. Pension freedom sounds like something from Braveheart - what's actually happening?
Only time will tell if these changes liberate older savers, or expose them to huge risk.
This is all about how you use your pension savings. As always you can take a quarter of it as a tax-free lump sum. Yet for decades most people have effectively needed to use the remainder of the money to buy an annuity - a product that pays you an income each year until you die.
Now, anyone aged 55 and over can take the whole amount as a lump sum, paying no tax on the first 25% and the rest taxed as if it were a salary at their income tax rate. That means if you take a huge whack, just like if you earn more, some of it will push you into the higher tax bracket. See my income tax calculator to see the various levels.
2. Does it apply to all types of pension?
No, we're only really talking private pensions where you and/or your employer saved up a pot of cash for retirement. Technically these are known as 'defined contribution' or 'money purchase' pensions.
It doesn't apply to the state pension, nor in the main part does it apply to pensions where what you're paid is a proportion of your final salary - known technically as 'defined benefit' pensions.
There are ways to convert these final salary pensions into a pot of cash (be very careful of scammers), but don't do it without genuine independent financial advice.
3. Is it worth taking out my pot as soon as I can?
Usually not. If you're in your 50s or early 60s you're probably still working towards retirement and should be focusing on putting yourself in a position to have enough income when you do retire - so you want your pension to keep growing.
Plus by accessing your funds earlier than needed, you can reduce your ability to make future contributions.
4. If I don't want to take it all out what can I do?
There are many options, some of them can be combined, here are the main ones.
Option 1: Leave it in your pension for when you need it. Then each time you withdraw, 25% of that amount is tax free. E.g., if you had £100,000 and took £20,000 out you'd get £5,000 of it tax-free, the rest would be taxed at your current rate.
Option 2: Take 25% tax free, then buy a flexible income drawdown product. This is a product you buy to keep the rest invested so it can still hopefully grow, but you can also use it to take income when needed. Here you get the first 25% you withdraw tax free and then the rest is taxed when you take it - possibly useful if you're likely to be in a lower-tax bracket once you're older.
Option 3: Take 25% tax free, then buy an annuity. This gives you a guaranteed income each year for the rest of your life. You may be surprised to see annuities in here, as there's been much negative talk about them, but actually annuities are a decent concept. You get the security of knowing exactly how much you can spend each year, and that it'll last for the rest of your life.
The problem is the rates haven't been very good, and 60% of people just got them from their pension provider rather than checking for better deals, especially people with poor health who could've got much better rates. Yet done right, with some of your pension, it can be a useful option for security of income for life.
5. How do I know how much cash I should take out?
That depends on when you'll die. The Office of National Statistics mortality stats does show likely odds. The typical life span for a man who hits 65 in the UK is another 18 years, a woman 21. Add a little on that for safety and it means unless you've bad health you probably want to spend around 4%-5% of what you've got a year.
6. Do you think lots of people will just use the cash to buy a Ferrari?
I don't think I need to warn you not to buy a Ferrari with the cash, as if you choose to do that, you know you're probably either rather rich already, know you're being foolish, or know that you ain't got long left. Actually, I'm far more concerned many will be nervous about releasing the cash in case they're left with none in old age and will therefore sit on it, never spending it, depriving themselves of the benefit and living a worse life than necessary. We're not an investing nation and are relatively risk averse, so I see this as being a real potential problem. There's also the worry that there's a lot of scammers about trying to tap people for cash too.
7. Where can I get help?
The government’s set up a free guidance (not advice) service calledPension Wise. This isn’t just a semantic difference – this system will tell you what you can do, not what you should do. It won’t include help on your benefits, nor on what product to get.
If you’ve a sizable pension pot it’s worth spending the £300 to £1,000 it’ll cost to get an independent financial adviser who can tell you what to do (get quotes from a few first). You can find a local one throughVouchedFor or Unbiased.